Annuities… What are they and how do they work?

Today, Certificates of Deposits are at an all time low causing people to take a closer look at annuities. To help you understand them better we have put together some brief questions and answers.

Q. Why would someone want an annuity?

A. The main reason is to obtain guarantees. Annuities provide:

• Guaranteed Interest rates- no matter what happens to the stock market. The insurance company assumes the risk in a bad economy, not you. At certain times, annuity interest rates are higher than Certificates of Deposits (CD’s)

• Guaranteed payments- collect as long as you live. If you live longer than your normal life expectancy the insurance company must continue to pay.

Q. I’m confused. I hear a lot about annuities but I’m not sure I fully understand exactly how they are supposed to work.

A. A simple way to understand is to compare an annuity to a life insurance policy. With a life insurance policy you pay a relatively small amount of money (the premium) to an insurance company. When you die they pay your beneficiary the full amount of insurance you purchased. The annuity works in the exact opposite way. With an annuity you pay a relatively large amount of money to an insurance company which then pays you a smaller monthly amount for as long as you live. Think of an annuity as something that keeps on paying and doesn’t stop until you die. That kind of annuity is called an Immediate Annuity.

Q. But I see advertisements saying people can “invest” in annuities, could you explain that?

A. Similar to CD’s, you can purchase an annuity with a guaranteed interest for a period of time. The term could be for 3, 5, and 7 years or longer. Instead of collecting monthly payments right away (which is called annuitizing) you can defer receiving payments. That is called a Deferred Annuity. You simply let the money grow and accumulate before you take it out.

Q. When can I take money out?

A. At the end of the term, you can withdraw the money without any penalty or charge, keeping all the interest earned. You may take money out sooner but there will be a stiff penalty.  Some annuities allow you to take out the interest earned free of charges each year while others allow up to 10% to be taken out each year without penalty.

Q. At what rate can the money grow?

A. That depends on the type of Deferred Annuity you purchase. There are three main types:

• Fixed annuities – They pay a guaranteed rate of interest. The insurance company determines what interest rate they will offer and guarantees the payment (for example 3 1/2% for a 5 year period). The principal and the interest are both guaranteed. This is the safest type of annuity.

• Variable annuities – The rate of return varies depending on the investment performance of the underlying investment. For example, you may have a choice of mutual funds to invest in. If they perform well you may earn more income. On the other hand, if the mutual funds do poorly you could lose money.

• Equity Indexed annuities – The rate of return is tied to how well an index performs (i.e. the S & P 500). These annuities combine aspects of the first two annuities. They typically guarantee a minimum rate of return (for example 1 to 2%) yet offer the potential to earn more than the minimum rate should the investment results do well.

Q. What is the downside to annuities?

A. Typically there are surrender charges if you decide to cash in an annuity before the term of the contract expires. For example, if you purchased a 5 year annuity and you cashed it in before the 5 years were up- you will be charged a penalty. Penalties range from 10% to 1% depending on how long you have kept the annuity. Unlike bank CD’s which are backed by an agency of the U.S. government; annuities are backed by the full faith and credit of the insurance company.

Q. Are there other things I should know?

A. Everyone’s circumstances are different. Before you make a decision seek out a trusted advisor for guidance.

AMAC is pleased to offer this service to our members.

Please call 888-262-2006 and ask for the annuity department to speak to a licensed agent.

Note: AMAC does not endorse any particular product or company. Check with your tax advisor on tax questions and seek legal advice when necessary. AMAC may receive a royalty in the event a sale is made on any products sold through the AMAC portal.

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Mark Goldring
7 years ago

If I say put $100,000 into an annuity and I am 80 years old. the CFP will et me an interest payment and then that interest is paid until I DIE, When I die where does the money that I FIRST INVESTED GO. Is it possible there wont be any money left to an inheritance or is the money we started out with is still there to distribute to your children, friends etc.

Gordon Raymer
9 years ago

Once most annuities start they pay only the principal of the starting value. From then on the monies remaining with the company, till all paid out, draw zero interest. Only the dollars value the annuity had at start are paid.

Be sure of what is done with remaining money if the annuitant dies before all the money in the annuity is paid out, The remainder may be paid to beneficiaries or it may be kept by the company.

Richard Levine
9 years ago

With full income taxes when you receive payments, and inflation over the years isn’t this a loser which might just tread water or worse?

Michael B.
10 years ago

With 30 years in the Financial Planning Business, Stephen and Davis are “Right on the Money” with their explanations about annuities. Keep in mind that these are tools to be used in the retirement planning process and are one piece of the puzzle. If you want to have some piece of mind and plan for an absolute guaranteed amount of monthly income that can include some tax advantages,(regardless of what the market does) than annuities can provide that without risk. Remember, everyone’s situation is different, and must look at each situation on an individual basis. No one thing is right for everyone. These discussions are valuable because they cause everyone to start exploring different scenarios and asking questions. It’s funny how no one questioned the managers of their 401K programs, but just went along with the program.

Donald Sutherland
10 years ago

I have seen no comments on taxable income. As proceeds of the annuity are received how is taxable income calculated. I recently received a 1099-R showing a gross distribution of $36,000. in box 1 and a taxable amount of $20,000. in box 2. No other information was given. If in fact the box 1 amount was the total annual payout from an initial investment of approximately $530,000. should not the taxable amount be $0. The original investment was made with after tax dollars.
Any comments would be appreciated.

Greg Malan
10 years ago

An advisor would need more information about your father, but yes, an annuity would be a great income producer.

Rick Malan
6 years ago
Reply to  Greg Malan

Annuities have your money tied up for many years after you first get them, due to the surrender fees that last for usually 10-20 years. Many annuities have fallen under Class Action lawsuits because they aren’t suited for Senior Citizens. I would suggest going to a real investment broker who can get you much better investments than annuities. There are many safe places to put your life savings without having to pay the high commissions and high surrender fees associated with these sort of “investments”.

R.E. Parker
10 years ago

My father was just 84. He has his life savings in an account that’s now down to paying only about 1%. Would he benefit from a Fixed Annuity without putting his entire savings at risk while providing him with, perhaps, a monthly income?

Greg Malan
10 years ago

Just read Davis Garrison’s accurate but complex post, and wanted to remind everyone that all investments can be good for the right need. It definitely isn’t a ‘one pill cures all’ situation. Fixed Indexed annuities can be a tremendous financial tool, but so can variable annuities. Have an expert financial advisor who has all financial concepts available to him give you his advice. He will undoubtedly recommend a blend of different investments to solve your needs. Diversity is the key!
Don’t be afraid — find the right advisor!
Have a great October 7th! I know I will. It’s my birthday =]

Ray Mears
10 years ago

I would like to propose to those seniors over 65 and their children to contact their Congessman/woman asking them to propose a bill that would allow those seniors over 65 to withdraw from their IRA’s tax free, up to 35K, for 3-5 years. We lost a heckava amount(10-30%) of the value of our portfolios in this recession.It would take more years than we have to get back to where we were. This tax free money would get back into the economy as we would buy necessities that we are now doing without, or pay for our incresing health care costs. The Fed. Government wastes more money each year and this bill would do more good than bad.I just read that the government can’t account for 30+ billion dollars spent in Afghanistan and Iraq. If they can just write that off, don’t let them write us off. Don’t we deserve a break? Please, write to your representative to get this ball rolling. Get your family involved. They might be having to help you out financially and this would give them some relief.

Davis Garrison
10 years ago

30 years in the Insurance/Financial Services business. Fee based RIA (Investment Advisor Representative), Series 65 securities licensed – the import of this, I must act as a Fudiciary, meaning – I must put the best interest of my clients ahead of mine. Important? – ask your current advisor if he is a Fiduciary. #1, the annuities most of you are referring to as Equity Indexed Annuities, are actually called Fixed Indexed Annuities, been around since 1995, and are one of the finest “safe money” vehicles in the marketplace. You can actually control a volatile market, using yield, as opposed to exposing your principle to market volatility. Your principle is guaranteed, your principle is not exposed to the market, but is used to purchase a AAA government long -term bond fund that produces an annual yield each and every year. This annual yield is the only thing that is at market risk, and is used to purchase an option on the performance of an Index, i.e., the
S&P 500 Index, the Nasdaq 100 Index, etc., or a combination of Index allocations, that can be reallocated annually. At the end of each year, any gains of that Index/Indexes are automatically captured, added to your account value, locked-in (called annual reset) and you cannot go below that level due to downside market, ever! A down year in the market – worst case scenerio – you have the same amount of money at the end of the year, as you had at the beginning of the year. Put in context – take the recession of 2000,2001,2002. S&P 500 Index down 50%. Let’s say you started with $100,000, at the bottom you now have $50,000. Now, 50% gain and you are back to where you began, right? Wrong – that gets you back to $75,000 – it takes a 100% gain to get back to $100,000. With the Fixed Indexed Annuities, you would have had no gain until the Index bottomed out and then bagan to rise. While you are recovering from your 50% loss, which is where many people were when the market tanked again in 2008-2009, you are being credited with gains with the Indexed Annuity. The new Lifetime Income Benefit Riders available for Fixed Indexed Annuities, are very reasonably priced, usually under 1%, guarantee a lifetime income, and you can literally run out of money, but never run out of income. Variable Annuities – get with a good advisor, get on a recorded speaker phone and call the Insurance company. Have the policyholder ask a list of questions regarding the fees, both disclosed and hidden, they are required to do this. Get the fee information directly from the company, not the advisor or agent who sold you the Variable Annuity – I think you will be surprised at the level of fees you are paying that you were not aware of, typically 2.5% to 4%. Decreases your gains by that amount, increases your loses by that amount. Variable Annuities are nothing more than Mutual Fund Sub-accounts wrapped in an Insurance wrapper. Beware! As far as Insurance companies as risky, check out how they are regulated, by each state insurance commissioner, they are required to put one dollar in surplus for every dollar that they have at risk. Example: AIG – Insurance Division very profitable, always has been, but they are totally separate from the bailed out investments unit of AIG. Last comment – why are we in the shape we are in, since the beginnign of the housing collapse? Do your own homework – after the crash of 1929, two Congressmen, Glass & Steagal, composed an Act, the Glass/Steagal Act – put a wall between Insurance Companies, Brokerage Houses, and Banks. Did this so the Crash of 1929 couldn’t happen again. Banks couldn’t do Brokerage business, Insurance Companies couldn’t do Banking business, etc. Separtion. In November of 1999, the Glass/Steagal Act was repealed by Bill Clinton – walls come down, now Brokerage Houses such as Bear Stearns can securitize toxic mortgages, Fannie, Freddie, Countrywide, Bof A, etc., and sell them globally. Don’t believe me, check it out. Get in front of a unbiased qualified advisor and check out Fixed Indexed Annuities, don’t have one client who has lost one dime!

G. D. McAnally, CFP
10 years ago

Stay far away from Indexed annuities until you understand the negatives as well as they positives that the insurance salesman tells you about. Many of the people don’t really understand the complicated formulas in these annuities. Get a second opinion from a fee based RIA that doesn’t sell indexed annuities before buying one.

Stephen Garland
10 years ago

MetLife is a great company. But, the annuity you are talking about is a Variable annuity with high fees and can lose money. It’s not a bad product, but you said you wanted out of market. It is in the market.

Stephen Garland
10 years ago

Here is the bottom line.

Equity Indexed Annuities.
1. Your money grows 2 ways. Stock index goes up, your money goes up. The index ( Dow or S&P or NASDAQ etc.) is tracked for a time period ( Monthly, Qtrly, Yearly, etc.) and then your money or return is based on the performance of the index. For example if the the S&P goes up 5% in a year and the insurance company contract states it will pay you up to 5% per year based on the index, you get 5% return on your money tax deferred until age 59 1/2 or income distributions.
2. You do not have to annuitize your annuity to receive income from the product. Many things determine income streams. Your age, your return, the product type, etc. There is no one size fits all.
3. Important fact for most if not all EIA’s. If the markets go down, you lose no money in the investment. Zero is your hero. You may lose some buying power from inflation but no capital loss. Same as a CD here. CD’s today don’t even outpace inflation.
As far as risk goes, I ask my clients how they feel about losing money. If they say I want the chance to grow my money and income later own with guarantees and no chance of losing what I have accumulated, and I do not want to outlive my money no matter how long I live or what happens to my health, and finally I want to pass on as much as possible, then an equity indexed annuity is the only thing that I have seen that will do this.

This cannot be done with 401k’s, mutual funds, stocks, bonds, or anything that may lose value. If there is something out there then please inform me so I can go and start helping my clients with that product.

[email protected]
South Carolina
Annuities, Life, Health, Planning.

Robert J
10 years ago

I want to get out of the market. My broker suggested MetLife an annual step-up compounded enhanced death bennefit annuity. Garranteed 4% yearly, is this a good deal ?

John K
10 years ago

My insurance agent says if one insurance company goes belly up, other insurance companies will make your investments, policies good. Is this true?

Robert Eoff
10 years ago

If an annuity is ONLY guaranteed by the full faith and credit of a particular insurance company, such an investment seems very risky. Can you say AIG, General Motors, Fannie, Freddie or Enron?

Greg Malan
10 years ago

My reply to Steve would be yes.
Find an independent financial advisor who is well versed in all investments including annuities, and make sure he has been in business long enough to know what he is doing.
If you believe he is trustworthy after your interview, then follow his advise.
Annuities can be right for people wanting to protect assets from age 45 to 90.

Steve Gallison
10 years ago

At a healthy 65 should I bother?

Jack K
10 years ago

I might add, I have a long term care policy that I bought when 55 years old.

Jack K
10 years ago

I prefer mutual funds rather than annuities. (I am an insurance agent)
The Vanguard Mutual Fund company is where my money is residing. They have a large array of options for retirees. No, I do not represent Vanguard. I merely invest there.

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